An Airline Stock Rebounds

Two weeks ago, my sister Jen faced a small crisis because the financial world beat up on her husband's employer, American Eagle. In a single day, American Eagle's parent company, AMR (NYS: AMR) , lost as much as 41% -- an amount that was almost too much for her to bear. She worried about her family's livelihood, wondering whether her husband should take an expiring job offer from another airline, if the bankruptcy rumors turned out to be true.

Luckily for her and AMR shareholders, the stock has recovered since then, gaining back most of what it lost that day. But with earnings season upon us, this may be a make-or-break quarter for AMR, especially as it considers a spin-off of Eagle into its own company. Though the company is expected to post a loss for the fourth consecutive quarter, the amount of this loss will be under close scrutiny as the airline tries to move back toward profitability.

An ugly industryThe airline industry has not been a great place to invest in over the past decade. The 10-year period began with the aftermath of 9/11 and has seen rising fuel and labor costs leading to bankruptcies and mergers since then. In fact, by September 2005, four of the top seven carriers in the U.S. were under Chapter 11 bankruptcy protection: United Airlines, US Airways (NYS: LCC) , Northwest Airlines, and Delta Airlines (NYS: DAL) . These bankruptcies led to a consolidation among the larger carriers, including the merger of United Airlines with Continental to form United Continental (NYS: UAL) .

Managing to stay out of bankruptcy was American Airlines, though that doesn't mean the stock has performed well. AMR shares have tumbled nearly 93% since reaching their high in January 2007, largely because of three consecutive annual losses, which were caused primarily by high labor costs. American Airlines has been negotiating a new labor deal since 2006, and pilots are seeking pay increases to make up for concessions they accepted in 2003 to prevent AMR's bankruptcy.

Smaller is often betterIn the airline industry, smaller or regional operators have seen better performance in recent decades. Southwest Airlines (NYS: LUV) is an active recommendation of our Motley Fool Stock Advisor service. Allegiant Travel (NAS: ALGT) has the best growth potential among airline stocks, with 38% sales growth and 43% EPS growth over the past five years. And fellow Fool Sean Williams considers both Alaska Airlines and JetBlue (NAS: JBLU) solid buys.

Smaller airlines benefit from fewer planes and routes, which lower the cost per available seat mile (CASM). They typically pass those cost savings onto passengers in the form of lower ticket prices or the avoidance of baggage fees. Larger airlines have to maintain a larger fleet of aircraft, regardless of whether those planes are currently in use on routes. The larger airlines' average CASM is $13.91; the smaller airlines' average is $10.90. Lower costs tend to increase earnings, so it's no wonder that smaller airlines make better investments.

Can AMR continue to compete?AMR recently decided to follow the lead of one of its smaller competitors. Instead of continuing to fly unprofitable routes, the company has decided to scale back its capacity for the remainder of the year, much like Allegiant Travel. Although this move could lead to job losses, AMR's issues can be traced to high labor costs, so cutting capacity by 3% over last year could align the company's long-term operating costs with those of its more nimble competitors.

In the past two months, 240 pilots retired, about 10 times the usual number. Mandatory retirement is forcing out some pilots, but many others may be retiring now to keep their pensions from being absorbed in a bankruptcy, or to simply lock in a higher price of their retirement funds, since they're allowed to cash out at the highest price within the past 60 days. When the law changed in 2007 extending the mandatory retirement age from 60 to 65, senior pilots maximized their pensions by working five more years.

The proposed spin-off of American Eagle would ease some of AMR's labor pains, as Eagle has had a history of positive labor relations with its unions. But since the two airlines fly different planes, the pilots from each airline are represented by different unions, and American's current labor woes with its pilots don't affect Eagle in the same way -- thus making the spinoff a quick way for American to trim the Eagle labor costs off of its books.

What to watch forAMR releases its latest quarterly earnings this week, and while most analysts expect a loss for the fourth consecutive quarter, the size of the loss will be worth noting. Another thing I'm watching for, more for my sister Jen than anything else, is when the American Eagle spinoff will happen. An independent American Eagle will provide better opportunities for her husband and offer some stability for them going forward. Keep up to date with all of AMR's news by adding them to My Watchlist -- it's free.